How Wall Street’s ‘fear gauge’ is being rigged, according to one whistleblower

One of the most popular measures of volatility is being manipulated, charges one individual who submitted a letter anonymously to the Securities and Exchange Commission and the Commodity Futures Trading Commission.

The letter makes the claim to regulators that fake quotes for the S&P 500 indexSPX, +0.26% are skewing levels of the Cboe Volatility Index VIX, -2.50% which reflects bearish and bullish options bets 30-days in the future on the S&P 500 to gauge implied stock-market volatility (see excerpt from the letter below).

The flaw allows trading firms with sophisticated algorithms to move the VIX up or down by simply posting quotes on S&P options and without needing to physically engage in any trading or deploying any capital. This market manipulation has led to multiple billions in profits effectively taken away from institutional and retail investors and cashed in by unethical electronic option market makers.

The whistleblower’s claims are consistent with those documented by John Griffin, professor of finance at the University of Texas and Ph.D. candidate Amin Shams in May 2017 in research that says the cost of manipulating less-liquid SPX options would be more than paid for by a successful bet on the direction of the VIX. The paper is consistent with the whistleblower’s conclusion—that manipulators are moving prices of the SPX options by spoofing at settlement—entering quotes for trades that are never executed—to “paint the tape” and, therefore, influence the value of expiring VIX derivatives.

The VIX has underpinned a number of strategies described as so-called short-volatility, which imploded dramatically last Monday when VIX, also known as Wall Street’s fear gauge, registered its largest percentage change in its history, cratering bets that volatility measures would fall, if not remain muted.

Short volatility products, notably, VelocityShares Daily Inverse VIX Short Term ETNXIV, -0.75%tumbled 90% in after-hours trade Feb. 5 as the Dow Jones Industrial Averaged DJIA, +0.16% plunged 1,175 points, or 4.6%, marking its sharpest point drop in the blue-chip gauge’s 121-year history. Another product, the exchange-traded fund ProShares Short VIX Short-Term Futures ETF SVXY, +1.86% known by its ticker SVXY, also tanked last week.

The spectacularly wrongway short bets had become one of the most popular trades on Wall Street because volatility had gone eerily absent for a protracted period, encouraging investors, who were lamenting the narrow trading ranges present during that period of placidity, to make more aggressive wagers to generate richer returns. Those moves also came amid ultralow rates for government bonds, particularly the 10-year Treasury note TMUBMUSD10Y, +0.13%

Jason Zuckerman, attorney at law firm, Zuckerman Law, who is representing the anonymous whistleblower, told MarketWatch that his client is concerned about unfair markets.

“My client is concerned about VIX manipulation that has already caused investors to incur massive losses and is eager to prevent further harm from investors,” Zuckerman said.

The whistleblower would also like the market regulates to play a more active role in preventing further harm to investors including requiring more accurate and comprehensive disclosures about the various risks that are associated with products linked to VIX,” he said.

The letter urges “the SEC and CFTC to promptly investigate the matter before investors suffer additional losses due to this fraud.”

Zuckerman’s whistleblower further charges that the average retail investor isn’t aware of how exchange-traded products like XIV are rebalanced daily and that a “mismatch” in the nature of short-volatility products means “a larger move in spot-volatility in either direction requires excessive buying or selling pressure whenever short volatility assets are dominant.”

Source: Zuckerman Law

One error that market participants have pointed out is that Zuckerman and his client in the letter refer to the CME Group Inc., at one point rather than the Cboe Global Markets Inc., which oversees the VIX product.

“This letter is replete with inaccurate statements, misconceptions and factual errors, including a fundamental misunderstanding of the relationship between the VIX Index, VIX futures and volatility exchange traded products, among other things,” a Cboe spokeswoman said in a statement.

Messages to the SEC and the CFTC weren’t immediately returned.

The whistleblower claim also comes amid heightened regulatory scrutiny around short-VIX products, including former CFTC Commissioner Bart Chilton, who told MarketWatch that warnings about products like XIV should be written in “big, bold 24-point font and in red letters.”

A CBOE press release said that Feb. 5-Feb. 9 was the busiest week in the exchange’s history with a record weekly high of 48.29 million contracts traded. However, shares of CBOE, which merged with merged with Bats Global Markets last year, lost 20% last week when after the market mayhem cast doubt on whether these products would remain viable choices for traders.

CBOE executives are confident its VIX product will continue to do well in all market conditions. On its earnings call, John Deters, CBOE’s chief strategy officer, told analysts, “It’s really an exceptional event when the level of VIX increases and doubles in a matter of just a handful of days. That’s occurred, and now we’re at a point where — and professionals know this — we’re at a point where the short VIX strategy tends to work quite well.”

CBOE Chairman and CEO Edward Tilly refuted concerns about the impact of the problems at some exchange-traded products and added that the exchange saw record trading volume in VIX futures and options in 2017. “The activity we see from issuers of XIV and SVXY is less than 5% of all VIX futures trading, representing average daily volume of about 12,000 contracts,” Trilly said. Non-institutional holders of these ETPs were approximately 21% of total holdings in the last reported period, he said, with the remainder consisting of “sophisticated institutional users who employ inverse VIX ETPs as part of a diverse mix of trading and investing strategies.”

Market’s wild ride could last weeks — with another jolt coming right behind it, Invesco top market watcher warns

The market turmoil may have a lot more life left in it, and just when it seems like it’s calming down — another jolt could be right behind it.

That’s the scenario Invesco’s Kristina Hooper sees unfolding. She predicts a plunge of this magnitude could happen multiple times in the next 10 months.

“I would expect whiplash to continue. The negative animal spirits that are in the market today don’t look like they’re abating,” the firm’s chief global market strategist said Thursday on CNBC’s “Futures Now.” “We could see this kind of tumultuous environment continue for days and perhaps weeks.”

“[It] really opened up a Pandora’s box of other concerns,” she said. “We’re looking through a very different prism at the same data, the same market events and extrapolating something far more negative.”

She’s also observing anxiety over potentially adverse consequences from tax reform and a new budget. To pay for it, the government could issue a lot more debt in the next year.

“That’s I think what is really gripping the markets with concern right now,” she said.

Despite her less-than-rosy forecast, Hooper still believes stocks could end the year about 10 percent higher. But getting there will be “lumpy and bumpy.”

“Investors need to be prepared for more volatility,” Hooper said.

Dow travels more than 22,000 points in one of the wildest weeks since the financial crisis

The Dow Jones industrial average posted its worst week in two years. Earlier in the session, the index was on track for its worst week since October 2008, during the financial crisis.

The stock index has traveled more than 22,000 points this week in a volatile few days that kicked off Monday with the Dow’s biggest closing point drop on record.

Stocks are falling as traders worry about rising interest rates, and volatility as measured by the VIX has jumped to its highest since the market turmoil of August 2015.

The stock index closed more than 1 percent higher, bringing its weekly losses to the worst since January 2016. Earlier in the session, the Dow was tracking for its worst week since October 2008, during the financial crisis.

CNBC tracked the volatile moves of the Dow this week to calculate the number of points the index has moved. In the past five trading days, including Friday, the Dow has traded about 20,000 points back and forth in a roughly 2,000-point trading range.

Stocks have plunged in the last week as traders worried about rising interest rates and inflation, bringing an end to more than a year of historically low volatility. On Monday, the S&P 500 broke its longest ever streak without a 5 percent drop from a recent high, according to Ryan Detrick, senior market strategist at LPL Financial.

The Dow suffered its worst daily point drop on record Monday, and briefly fell nearly 1,600 points intraday. The index recovered about half of Monday’s losses in a volatile Tuesday session, but has closed lower in each of the two days since.

On Friday, the Dow jumped 349 points in morning trading, fell 500 points later in the session, before closing 330 points higher.

The Cboe Volatility Index (.VIX) jumped Tuesday above 50 for the first time since the market turmoil of August 2015. It traded near 29 late Tuesday afternoon.

The recent period of mild volatility is what’s making the current market sell-off appear so shocking, according to two experts.

On Thursday, U.S. stocks fell sharply as strong earnings and economic data were not enough to quell jitters on Wall Street. The Dow Jones industrial average fell more than 1,000 points and entered correction territory — it is also on track to post its biggest weekly decline since October 2008. Meanwhile, the S&P 500 fell 3.75 percent and the Nasdaq composite declined 3.9 percent on Thursday.

“It’s just been an unusually long period of mild volatility that makes this seem so rough,” Bill Smead, CEO and CIO of Smead Capital Management, told CNBC’s “Squawk Box” on Friday.

Smead said there’s about a 30 percent chance of losing money from the time an investor enters the stock market to a year later. But because of low volatility in recent years, that hadn’t been the case. “It’s just been so long since we did that, that this (sell-off) seems so shocking,” he said.

“If you go back and look at the first 15 or 20 years I was in the business, from say 1980 to 2000, you have a 10 percent decline peak to trough almost every year that I’ve been in the business, except this last year-and-a-half,” Smead explained.

The sell-off started last Friday morning when the U.S. labor department reported that average hourly earnings increased more than expected in January. Though it was a good news for workers who had flat wages for years, investors became nervous because it meant rising wage pressures and inflation could force the Federal Reserve to raise interest rates higher than the market was expecting.

As a result, volatility in the market rose. On Tuesday, a key measure of market volatility, the CBOE Volatility Index, briefly rose above 50 — the highest level since August 2015. On Friday morning Asia time, the VIX hovered near 33.

“When you see volatility start to rise, it really starts to impact the market in a way that we haven’t seen in a long time, which is that there’s risk in the system again,” Jay Jacobs, vice president and head of research at Global X Funds, told CNBC’s “Squawk Box.” The market had become expensive because the global economy was doing well, there was strong earnings growth and there was no risk in the system, he said.

“Obviously a lot of people are looking at the 10-year Treasury and they’re looking at deficit spending, but it’s the second-order effect of now stocks having risk in them and that changes the equation for how you price in that risk,” Jacobs said. He added that a lot of buying and selling in the market was investors adjusting their risk assumptions for 2018.

I like banks here as a place to hide out from possible rising U.S. inflation. Not only have they benefited from a deregulatory environment, but we’re also starting to see life in the yield curve. The all-important 2/10 spread is banging around at 76-77 basis points as I write this, up from 50-ish very recently.

Meanwhile, the market’s recent volatility should benefit the more aggressive names among the banking group. Amid last week’s madness, I initiated longs in both Bank of America (BAC – Get Report) and Goldman Sachs (GS – Get Report) , with small nibbles close enough to the week’s lows.

I bought Bank of America for the prospect of improving conditions for traditional banking and Goldman for its known aggression when markets allow traders to trade. As the week starts, I’m up small in Bank of America and down small in Goldman Sachs. Let’s take a look at Bank of America’s chart and see what I see:

What stands out on this daily chart of BAC? First, the Chaikin Money Flow (CMF) remains positive despite a weakening Relative Strength Index.

There’s also a very sloppy Moving Average Convergence/Divergence oscillator (MACD) that sports a nine-day exponential moving average deep in negative territory. What I see is support that did indeed show up at almost a precise 38.2% retracement off of the recent top. This stock also closed Friday at its 50-day simple moving average, which will only be significant in hindsight if this works.

Now I know that I’m going out on a limb here, but if that Fibonacci level holds and forms the crook of the Pitchfork’s elbow, I see support for Bank of America rising to levels around $32 within a month.

Am I crazy? My wife thinks so, but I’m not a daredevil. I’m only long about an eighth of my targeted position size.

Should Bank of America take off, this becomes a trade rather than an investment. But should we head toward last week’s lows and beyond, I have plenty of dry powder set aside for this one.

(A longer version of this column appeared at 9:20 a.m. ET on Real Money, our premium site for active traders. Click here to get great columns like this from Stephen “Sarge” Guilfoyle, Jim Cramer and other experts every market day.)